1. Please provide the source for answering following questions.
a. What is the spot exchange rate for the US dollar today vis-à-vis the yen? What are the
30-day, 90-day & 180-day forward exchange rates?
The spot exchange rate is 1 USD = 81.796 JPY. Forward exchange rates are the rates in which
the delivery of foreign exchange is done after certain specified future period. So, a foreign
exchange contract in which the payment has to be settled after 30-day maturity contract is
called a 30-day forward exchange rate. Similarly, when a contract is agreed upon for 90 days or
180 days they are called 90-day and 180-day forward exchange rates. In these types of rates
the payment of the foreign exchange becomes due after the, 30 or 90 or 180-day period at the
initially agreed forward exchange rate and is not affected by the spot exchange rate.
a. Is the Japanese yen at a forward premium or forward discount relative to the US
The JPY is at forward premium relative to USD because the difference between
forward rate and spot rate is positive.
b. What was the spot rate exactly one year ago? Comparing that to the current quote,
has the Japanese yen appreciated or depreciated?
The spot rate exactly one year ago was 1USD = 78.765 JPY, comparing this to
current rate, the JPY has depreciated.
c. If you expect to be paid 100 million yen by a Japanese buyer in 90 days, is there any
simple way to hedge the risk arising from this future payment based on the data you
have seen so far?
The simple way that one can hedge the risk arising from the future payment is to do
transactions is in the forward market ( forward exchange rates).
Source: Pacific Exchange rate service – FX charts
2. Please read the following article & comment on the impact of these actions on the
currencies of the countries discussed in the article, including the US dollar.
Bank of England Slashes Interest Rates to Lowest Level Since 1955: The ECB Cuts Too
The Bank of England’s and ECB’s decisión to lower the interest rate will affect the
Sterling and Euro towards downside. The sterling and Euro assets will not appeal to
investors and both the currencies will depreciate in value which will cause more
expensive imports for England and Eurozone, but other nations will be interested in their
exports. As a result, activities in Eurozone would slow down more. All other countries which
followed the BOE and ECB decisions will face the same situations. As Euro will depreciate
that means Dollar should appreciate and soar to new highs.
3. Suppose the dollar-pound rate equals $0.5 per pound. According to the purchasing
power theory, what will happen to the dollar’s exchange rate under each of the
a. The US price level increases by 10% & price level in Britain stays constant
The dollar will depreciate by 10 % relative to pound.
b. The US price level increases by 10%, while price level in Britain increases 20%
The dollar will appreciate by 10 percent relative to the pound.
c. The US price level decreases by 10%, while price level in Britain increases by 5%
The dollar will appreciate by 5% percent relative to the pound.
4. Suppose GM is considering buying a plant in Hungary. All sales will be to Hungarian
customers & denominated in forints. The projected returns & investments are as
Purchase price 30 billion forints
Additional investment $50 million, all imported from US
Projected Hungarian sales 45 billion forints
Projected earnings 4.5 billion forints
Exchange rate 300 forints/$
a. What is the total investment in dollars?
300 forints = 1 $
So 30 billion forints = 100 MILLION $
Now total investment will be purchase price + additional investment
= $100 million + $50 million = $150 million
b. If the forint is devaluated 25%, what is the new exchange rate?
Forints is devalued by 25 % that means 25% of 300 forints i.e, 75 forints is added
and so new exchange rate is 375 forints per USD
c. If this 25% devaluation was made after the purchase & additional investment was
completed, what is the new ROI?
The new ROI will be lesser then earlier one.
d. Instead of selling to the Hungarian market only, suppose all sales were exports,
priced in hard currency, yielding the same 4.5 billion forints earnings (at the original
300 forints/$ exchange rate). If the 25% devaluation now occurred, what would
happen to the plant’s profit margins?
The profit margins will increase by the amount of devaluation of currency. If earlier
profit margin is 4.5 billion forints @ 300 forints = $ 1 , now as the forints is devalued
so the now @ 375 forints = $ 1 the profit margins will be more as it will be easier to
5. Discuss if & how a country can achieve monetary independence, full capital mobility
& a fixed exchange rate simultaneously. Justify your answer properly.
The trinity or the macroeconomic trilemma, that is, fixed exchange rate, full capital
mobility and monetary policy independence is impossible and under any macroeconomic
condition, only two goals can be mutually consistent and it is to be decided by the policy
makers which third goal is to be given up. “The intuition is when a country has an open
capital account and the exchange rate is pegged to some base currency, simple interest
rate parity will pin down the domestic interest rate, forcing it to be equal to the interest
rate of the base currency, if not, capital will flow until they do” (Obstfeld et al., 2004).
Figure 1 shows this trilemma. “The corners of the triangle show the policy goals, any
pair of goals is achievable but requires the third goal to be abandoned”. (Joshi, 2003)
(i) Stability of exchange rate and full capital mobility can be achieved by adopting
a permanent fixed exchange rate but monetary independence has to be
(ii) Free capital mobility and monetary independence can be mixed by adopting a
floating exchange rate but exchange rate stability has to be surrendered.
(iii) Monetary independence and exchange rate stability can be achieved but
capital mobility has to be surrendered.
Figure 1: The Trilemma
Exchange rate stability
Monetary Autonomy Capital mobility
The impossible trinity states that only fixed exchange and free floating rates are sustainable
systems with increased capital mobility. “This is described as two corner solution or bipolar view
or hollowing out of the middle.” ( Eichengreen, 1994)
However some economists like Frankel (1999) commented that the menu of choice between
floating and fixed exchange rates has been artificially restricted by the impossible trinity. Frankel
wrote, “What then is the origin of the hypothesis of the disappearing intermediate regime (the
“missing middle?”)? …….this is not the same thing as saying one cannot have halfstability and
half independence. There is nothing in existing theory that prevents a country from pursuing a
managed float ……..”(p.5, 1999). Frankel (1999) named this as “intermediate regime”.
Hannoun wrote, “an intermediate solution has a certain appeal, i.e. there might be some kind of
optimal weighting among the three objectives” (p.3, 2007). India and Malaysia are good
examples of these intermediate systems. But for all the three choices to be managed
intervention in the market is required which has its costs. The best choice perhaps, is to
maintain price stability, liberalize capital flows and let the exchange rate float.
6. Summarize the three leading models of exchange rate determination.
The exchange rate can be determined by:
The first model is the simple monetary model that tells how the current and future
values of foreign interest, income level and money supply make the changes in the
exchange rate and price level.
The second model, General exchange rate equilibrium model known as the
Mundell- Fleming model deals in the equilibrium of the money market, goods
market and balance of payments; It is nothing but an extended form of a closed IS-LM
model. It makes assumption of presetting of prices in the short run. It forecasts that a
country can’t achieve monetary independence, full capital mobility & a fixed exchange
rate simultaneously and if inflation, BOP and fiscal discipline are not well managed than
a devaluation of currency may result in further devaluation.
The third model known as Dornbusch model shows that in case of real economic
shocks, a flexible exchange rate or change of prices makes the market to move towards
equilibrium. Unlike the Mundell-Fleming model it allows for slow price movements to set
exchange rate flexible. Frequently, all three models are criticized because they lack
micro fundamentals, and don’t consider the effect of the balance of payment on the
determination of the exchange rate. However, their impact should not be
underestimated for making policy.
7. Explain the differences between a currency board, a fixed exchange rate system & a
pegged exchange rate. Which is the most credible & why is credibility so important?
Basically all three are fixed exchange rate systems and the mainly inter related in the
form of their functioning.
A fixed exchange rate system (Bretton-Woods system) is the system in which
assuming that stable exchange rate by reducing uncertainty and fluctuations in relative
prices will help in facilitating in trade and investment, exchange rate is kept pre
announced for the currency and then domestic currency is bought and sold at that rate.
Under this the excess demand or supply is absorbed by the central bank and the pre
set rate may or may not coincide with the equilibrium exchange rate.
The fixed exchange rate of system, in which the value of the currency is fixed by the
central bank, but the value of the currency can be changed either in pre determined
manner or in a arbitrary way, whenever it is desirable, is known as pegged exchange
rate system. In this, If a central bank does not have enough foreign reserves, it may
allow floating or devaluation of the currency. This system reduces the volatility of the
exchange rate (at least in the short-run) and the imposition of some restrictions on
government policies. However in this system currency speculation may be introduced
In order to avoid running out of reserves, some countries like Argentina and Hong kong
adopted a system known as currency board. Some fixed exchange rate systems are
known as currency boards and a currency board is a authorised body of government
whose work is to maintain its exchange rate fixed in terms of a foreign currency. A
keeps unlimited convertibility and absolute between its currency and the anchor
currency, at a fixed exchange rate, without any restrictions on current or capital account
Neither lends to the government nor allow it to print money but has no powers to effect
policy related to monetary matters.
No fixed exchange rate system is absolutely and unconditionally credible but among the
three the most credible fixed exchange rate system is a currency board. The
creditability is important because a currency board requires minimum 100%
international reserve backing of the monetary base which in turn depends on the cost
and difficulty of abandoning it.
Eichengreen, B. (1994). International Monetary Arrangement for the 21 Century,
Washington, DC: Brookings Institution.
Frankel, J. (1999). “No Single Currency Regime is right for all countries at all times”
Essay in International Finance 215, International Finance Section, Princeton University
Hashimoto, Y. (2008). “Too Much for Self-Insurance? Asian Foreign Reserves”, Hong
Kong Institute for Monetary Research Working Papers, 062008.
Hannoun, H. 2007. “Policy response to the challenges posed by capital inflows in
Asia”, speech for the 42 SEACEN Governors’ Conference, Bangkok, 28 July
Joshi, V. 2003. “ India and the Impossible Trinity” , The World Economy, Vol 26,
4(04), p.555 – 583.